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1 – How to calculate or decide the current price & exercise price in a case study of BSOP model. I mean to say on what basis we will decide which one will be current price & which one will be exercise price in a case or scenario.
2 – I have come across in several question the cost of equity has calculated on asset beta or un geared beta rather than geared/equity beta. is it correct to calculate the Ke on asset beta. if it is on what circumstances Ke will be calculated on asset beta.
Pls help me out.
Thanks.
1 The question will have to give you the relevant figures.
2 The cost of equity (Ke) is always determined by the equity beta. The only time the equity beta will equal the asset beta is when there is no gearing in the company.
Like in jun-2011 question # 3, how current share price(Pa) & exercise price(Pe) has been calculated .
same how we will decide current share price & exercise price in OPTION TO DELAY,OPTION TO EXPAND,OPTION TO ABANDON.Pls clear my doubt…
JUN-11
3 – MesmerMagic Co (MMC) is considering whether to undertake the development of a new computer game based on
an adventure film due to be released in 22 months. It is expected that the game will be available to buy two months
after the film’s release, by which time it will be possible to judge the popularity of the film with a high degree of
certainty. However, at present, there is considerable uncertainty about whether the film, and therefore the game, is
likely to be successful. Although MMC would pay for the exclusive rights to develop and sell the game now, the
directors are of the opinion that they should delay the decision to produce and market the game until the film has
been released and the game is available for sale.MMC hasforecast the following end of year cash flows for the four-year sales period of the game.
Year 1 2 3 4
Cash flows ($ million) 25 18 10 5MMC will spend $7 million at the start of each of the next two years to develop the game, the gaming platform, and
to pay for the exclusive rights to develop and sell the game. Following this, the company will require $35 million for
production, distribution and marketing costs at the start of the four-year sales period of the game.
It can be assumed that all the costs and revenues include inflation. The relevant cost of capital for this project is 11%
and the risk free rate is 3·5%. MMC has estimated the likely volatility of the cash flows at a standard deviation of
30%.Required:
Estimate the financial impact of the directors’ decision to delay the production and marketing of the game.
The Black-Scholes Option Pricing model may be used, where appropriate. All relevant calculations should be
shown.?The option applies to the spending of the $35M – they are going to spend $7 a year whether they delay or not.
So the option is the right to delay the $35M and therefore also delay the later cash flows.Pa, is always the value of whatever is being delayed (in the case the PV of the later cash flows) and Pe is always the amount that is needed to pay out (in this case $35M).
The same logic would apply to options to expand or to abandon, although in this case it could not be done because of lack of information (and there is almost no doubt that any real option calculations in the exam will be options to delay – the others would almost certainly just be points in the written parts of questions).
In above mentioned question did we have to take PV of all cash flows or after 2 years , and what we have to do of $7. One more query is that in this question our time remain 4 years?
I am not 100% sure that you are asking. However, the question says that it will be 22 + 2 months (i.e. 2 year) before the game will be available (and therefore before we start earning money from it).
So…..we have to pay out 7M now and in 1 year, and 35M in 2 years. Then we start receiving income from time 3 onwards for four years in total. So the whole project goes on for 6 years.
Ignoring the option we work out the NPV now of all 6 years of flows.
Because there is the option to delay, the value of the option makes the project more worthwhile.I hope that answers your problem, but if not then ask again.
Sir in the same question when we calculate present value of cashflows by applying the discount factor of 11%we get 47.75m so are these cash flows at year 0 or after year 2 as i cannot understand why have we multiplied 47.74 to 2 year discount rate in order to get 38.77m which is the pv of returns after 2 years so confusing please explain
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